Emerging markets: Pick your multinational carefully

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One of the most popular strategies for investing in emerging markets has been to avoid them. That is, forget about China, India and Brazil, and instead invest in North American- and European-based multinationals that have expanded aggressively into these countries.

That way, you get exposure to fast-growing economies with rising consumer spending. And you don't have to surrender the management talent and higher accounting standards normally associated with developed markets.

But the strategy is now on its heels.

The Economist noted that the STOXX Global 1800 (Emerging Markets) Exposed index, a collection of Western companies with high emerging-markets exposure, has underperformed the S&P 500 by about 40 per cent over the past three years.

The STOXX index is down about 20 per cent from its high in 2007.

One explanation is that multinationals have been undisciplined in their expansion. They have been paying steep prices for takeovers in a frenzy to gain market share, only to gain access to saturated markets that generate disappointing results.

The Economist singled out Vodafone Group PLC: It invested $25-billion (U.S.) in Turkey and India, only to get a measly 1- per-cent return on capital last year.

More ominously, the magazine wondered if the rush into emerging markets will one day resemble a "giant version" of the 1990s Internet boom.

It's enough to make you wonder if investors have followed multinationals far too enthusiastically over the years, chasing a grand investing theme even as it starts to look worn out.

But rather than avoiding multinationals with emerging markets exposure, the key is to take a more discerning approach. There are a number of success stories here – and if the world loses any more interest in emerging markets because of currency volatility and geopolitical uncertainty, they could become terrific opportunities.

Yum Brands Inc. is a good, if overused, example of a company that has done well with its expansion into China, where it increased the number of KFC and Pizza Hut locations by more than 500 last year.

The share price has risen more than 50 per cent since the start of 2011 and is near a record high. By comparison, the struggling STOXX Global 1800 (Emerging Markets) Exposed index is flat over this period.

Starbucks Corp., which has also been expanding aggressively into Asia, has performed even better, rising more than 120 per cent since the start of 2011, even after retreating 11 per cent over the past four months.

These companies look like a sweet spot for multinationals doing business in emerging markets: Their products appeal to consumers whose level of affluence is rising, with brands that are somewhere between staples and luxury goods.

Consumer staples companies such as Procter & Gamble Co. and Unilever PLC have pretty much established that emerging markets are their only areas of growth.

But it's no cakewalk: In the case of P&G, expansion has come at the cost of declining profit margins. As well, their respective share prices have lagged the S&P 500 over the past few years, eroding their value as emerging market plays.

The other end of the spectrum is no better.

Luxury companies such as Prada SpA, LVMH and Coach Inc. have been struggling with declining emerging market currencies, slowing economic growth and rising concern about government corruption in China, where bling is being frowned upon.

The lesson: There was a time when following any multinational into emerging markets looked like a sound approach. Now, investors need to get picky.